Pricing currency options under double exponential jump diffusion in a Markov-modulated HJM economy

• Published in: Review of quantitative finance and accounting 2016-04, Vol.46 (3), p.459-482
• Main Authors: Chiang, Mi-Hsiu, Li, Chang-Yi, Chen, Son-Nan
• Format: Article
• Language: English
• Subjects: Accounting/Auditing; Brownian motion; Corporate Finance; Currency options; Econometrics; Economics and Finance; Euclidean space; Finance; Foreign exchange rates; Foreign exchange translations; Interest rates; International finance; Operations Research/Decision Theory; Original Research; Parameter estimation; Put & call options; Rates of return; Securities prices; Studies; Time series; Volatility
• ISSN: 0924-865X; 1573-7179
• DOI: 10.1007/s11156-014-0478-9

Extending the framework of Amin and Jarrow (J Int Money Financ 10:310–329, 1991 ) and Bo et al. (Insur Math Econ 46:461–469, 2010 ), this study provides a theoretical exploration of currency options pricing under the presence of interest-rate regime shifts and exchange-rate asymmetric jumps. Evidence of interest-rate regime shifts inferred from UK and US zero coupon bond yields provides support for the regime-switching specifications which we reflect upon the domestic and foreign forward rates. Results of statistical tests conducted on JPY/USD and EUR/USD FX rates provide further support the rationale behind using a double exponential jump diffusion process within a Markov modulated Heath–Jarrow–Morton economy. Our numerical results suggest that, the pricing performance of our model is closely comparable to the Bo-Wang-Yang model for at-the-money options, yet yields improvements in percentage root mean errors for in-the-money options.